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Finding Value in Frontier Markets as Ukraine Crisis Continues

Investors seeking diversification away from emerging market equities flocked to frontier market (FM) equity funds in 2013. The category is small but growing, amassing a record $3.7 billion last year in mutual funds, ETFs and other investments. Although Frontier funds are a relatively new category within the massive ETF industry, assets allocated to funds offering frontier exposures more than doubled in 2013 and now stand at $835 million.

The draw? In the current market environment, investors want potentially higher long-term growth rates, reduced risk through low correlation to U.S. equity markets, and a virtually untapped investment opportunity, to name a few. What's more, the MSCI FM Index has historically been less volatile than the MSCI EM Index and the S&P 500. While individual companies and even countries can be highly volatile within frontier markets, taking a diversified approach by owning a basket of companies and countries can surprisingly lead to a much less volatile overall investment.

S&P 500, MSCI EM & MSCI FM Historical Volatility

However, recent headlines touting turmoil in several FM nations are forcing some to wonder if these havens are worth the hype. Last month, the president of Nigeria suspended the governor of the nation's central bank, sparking a selloff in the financial markets.

Tensions in Ukraine are also escalating. Protests broke out after President Viktor Yanukovych turned down an EU trade deal in exchange for Russian financial support, leading to his eventual ouster. The nation's currency fell to a new low against the U.S. dollar. Ukraine's interim government went on to call the unofficial presence of Russian troops at border posts in Crimea a "declaration of war" and put security forces on high alert. What's more, Ukraine is now appealing for a $15 billion bailout from the International Monetary Fund. These events have led many to wonder if the rush into frontier market equities has run its course. Some go so far as to conclude the sector is overvalued.

We disagree with both sentiments. First, as my colleague Russ Koesterich highlights in a recent Blog post, there is much value to be found in frontier markets. He says that the geopolitical risk inherent in investing in this asset class has always been there and is nothing new, though the specific countries experiencing unrest change over time. This is where being selective about how you invest comes into play. For example, the iShares MSCI Frontier 100 ETF (FM) currently has no exposure to Ukraine, instead focusing the majority of its holdings on the Middle East. We see three possible scenarios playing out in the short term in Ukraine:

Keeping the Status Quo (base case): Russian troops will stay in Crimea, but immediate tensions will ease somewhat as talks with the EU continue, stifling action from either side. A large scale conflict is not in Russia's best interest, and could trigger retaliations.

Ukraine civil unrest: Russia doesn't move into Ukraine but violence escalates. Ukrainian unofficial forces could also be deployed to Crimea. If this happens, the collateral damage to neighboring countries and banks could be significant.

Large scale conflict: Official armies are involved, followed by international retaliation. We believe this outcome is highly unlikely.

While we think that frontier market equities on the whole are no longer cheap, we don't think valuations are necessarily distorted. This could change if we see another strong run this year, but for now, we believe valuations appear reasonable.

Dodd Kittsley, CFA, is the Global Head of ETF Research for BlackRock and a regular contributor to The Blog. You can find more of his posts here.

Holdings are subject to change. There can be no assurance that any security will remain in or out of the funds.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets. Frontier markets involve heightened risks related to the same factors and may be subject to a greater risk of loss than investments in more developed and emerging markets.

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